LONDON, March 1 (Reuters) – Traditional commodity traders are lamenting the rise of a new generation of hedge funds who show little interest in the fundamentals of conventional supply and demand analysis.
The newcomers are blamed for distorting prices, making markets impossible to trade, and forcing the closure of some long-established specialist commodity funds.
The target of this criticism is not always well-specified: it variously includes high-frequency computer-driven traders, momentum-chasing hedge funds and macro funds dabbling in energy markets.
But the newcomers are operating on a scale never seen before in energy markets, with record open interest in futures and options contracts linked to crude oil and refined products.
Money managers, a category which includes many hedge funds and other investors, have accumulated record positions in crude, gasoline and distillates since the middle of last year, according to regulatory data.
By the end of January, money managers had established a bullish position in futures and options contracts equivalent to almost 1.5 billion barrels of crude, gasoline and distillates.
The net long position was more than 400 million barrels higher than the previous peak in February 2017 and almost 700 million barrels higher than the peak before that in June 2014.
“Who trades oil is changing,” according to the Financial Times (“Fundamentals do not matter to a new breed of oil speculator”, Feb. 27).
“Investors who bother little with details such as inventories and pipeline flows are replacing dwindling ranks of specialist commodity funds. The shift could alter the way prices are formed.”
Criticism that outsiders are distorting the proper function of commodity markets is as old as commodity markets themselves.
Computer-driven algorithmic and high-frequency traders have been blamed for exacerbating short-term price volatility for over a decade.
Commodity specialists complain the prevalence of high-frequency trading has reached a tipping point, distorting prices and forcing the closure long-established hedge funds (“Data overload: commodity hedge funds close as computers dominate,” Reuters, Feb. 12).
The complaints are an echo from a decade ago, when pension funds and other index investors, labelled “massive passives”, were blamed for driving up food and fuel prices in 2007 and 2008.
It is worth noting that high-frequency traders and index investors have been blamed for opposite problems (one for trading too much, the other for trading too little) yet are often lumped together.
Such criticisms are not new: I can remember similar comments when I first worked on a trading floor in the early 2000s.
Commodity producers and consumers have long blamed “speculators” for distorting prices that should be set by physical supply and demand.
In turn, specialist speculators blamed an influx of “hedge funds” and technical “black box” traders for worsening volatility. Now hedge funds blame high-frequency traders and “macro tourists”.
It is the familiar cry of the incumbent establishment against innovators and insurgents, reinvented for each generation.
“All traders on futures markets, other than hedgers, are speculators,” wrote economist Blair Stewart, almost 70 years ago, in what remains probably the most in-depth study of futures trading.
“Frequently these speculators know little or nothing about the commodity in which they deal, and have little knowledge of the methods of producing, grading, shipping, storing and using the product,” Stewart noted.
Stewart concluded that lack of specialist knowledge did not have much effect on the profitability of their trading (“An analysis of speculative trading in grain futures,” Commodity Exchange Authority, 1949).
“Many traders are concerned almost entirely with very short-run price fluctuations,” Stewart discovered after analysing thousands of customer trading records from the 1920s and 1930s from a large brokerage in Chicago.
Stewart noted that many traders implemented a strategy as if there was “a definite price level around which short-term fluctuations will oscillate”, buying when prices fell below it, selling when prices rose above.
Others tried “to detect short swings in the market at their inception” and put on a position intended to benefit from continued movement in the same direction.
Stewart termed these two groups “level” traders and “movement” traders. The modern equivalents are “mean-reversion” and “momentum”. But the strategies themselves have not changed.
The critical point is that all these strategies were based on prices themselves rather than a detailed analysis of supply and demand fundamentals.
The roles of speculation versus fundamentals was already controversial in 1949. “The role of the small speculative trader in the futures market has been the subject of much discussion,” according to Stewart.
“On the one hand it has been held that such traders are a disturbing influence in the market, accentuating price swings, and on occasions contributing to wild and disastrous price fluctuations.”
“On the other hand it has been maintained that such traders are a necessary element in the market since their presence makes it possible for the expert trader — who is presumed to exercise a beneficent influence on prices — to find traders to take the opposite side of his trades, and supply through their losses the income which is necessary to support the continued trading activity of the professional.”
The debate has continued more or less unchanged in the intervening decades — in most cases generating more heat than light.
While some researchers and commentators insist price movements are entirely explained by fundamentals, and others entirely by speculation, most accept prices are driven by a mix of both.
Fundamentals clearly dominate price formation in the long term. Speculation likely drives price movements in the short term. And between the two time horizons fundamentals and speculation both play a role.
Speculation can accelerate and exaggerate price movements, causing them to overshoot in the short term, but in the longer term, prices reflect underlying production and consumption conditions.
Speculation likely adds to short-term volatility, but it may also dampen price fluctuations in the medium term by accelerating the price discovery process.
There is a temptation to see fundamentals as the cause of good/stabilising/logical price moves while speculation is responsible for bad/destabilising/illogical ones.
There is also an incentive for traders, analysts and journalists to ascribe price movements to fundamentals when they predict them correctly and agree with them, but blame speculation when prices move in the opposite direction.
In practice, it is neither possible nor sensible to try to decompose price movements in this way, which makes the whole argument about fundamentals versus speculation somewhat empty.